How Presidential Elections Affect the Stock Market

This year marks the 59th quadrennial US election. The president assumes office the following January after the election. Once the elected president takes office, their primary objective would be to strengthen the economy and generate growth. It is this consistency in the U.S. political process that also sets into motion fiscal policies that are frequently predictable and that often have a direct effect on the stock market. In the discipline of economics, fiscal policy is defined as an increase or decrease of taxes and/or government spending. The direction that fiscal policy takes, can often be directly related to the state of the economy at the time a new president is elected.

It is not surprising to see incumbent presidents push for votes by proposing tax reductions or increasing spending on specific government programs as an election draws near. In addition, an incumbent political party may also try to persuade the Federal Reserve to complement the administration’s efforts through monetary policy, by increasing the money supply and reducing interest rates. Such fiscal and monetary policies may be introduced as early as the end of the second year of the presidential four-year term. If the results are favourable and the economy responds positively, corporate profits usually rise, and with them stock prices, just in time for the next presidential election.

These policies can also lead to inflation, which can be disconcerting to investors. If this were to happen, a newly elected president could be pressured to reverse the fiscal and monetary stimulus policies of his or her predecessor, attempt to get inflation under control, and then hope to return to stimulus policies by midterm in preparation for the next election.

On the surface, the concept of inflation appears to be straightforward. Inflation is understood to mean rising prices. However, the real questions an investor should ask are what caused it, why can it ultimately be a negative for the stock market, and what can be done to reduce it. First, if inflation is the result of excessive fiscal and/or monetary stimulus, known as demand-pull inflation, simply reversing the stimulus policies can help to lower inflation. If, however, rising prices are caused by external factors like rapidly increasing global oil prices, known as cost-push inflation, it can be much harder to control. Since the mid-1980s, the U.S. economy has not seen much cost-push inflation.

When the Federal Reserve increases or decreases interest rates, it is often to combat inflation, to position the U.S. dollar for favourable international trade, or to address a weakening economy. The consequences of rising interest rates are increased costs for businesses and consumers, which in turn can slow aggregate spending and corporate profits, and ultimately depress stock prices.

The above sequence of events appears to be logical and may be taken for granted by many investors, but what they may fail to understand is that the sequence does not always work in lock step. In other words, the effects of rising interest rates often lag in its efficacy and may not have an immediate negative influence on the economy. This lagged relationship between rising interest rates, falling corporate profits, and ultimately declining stock prices can confuse unaware investors. This is because corporate profits can, for a period, continue to increase faster than the negative effects of rising rates. Simply put, over time rising interest rates can put downside pressure on stock prices. However, in the early stages it may not be entirely obvious what is happening to all but the most sophisticated investors, who can bid down stock prices in concert with the anticipation of falling corporate profits.

The inverse is also true: any effort to curb recessions with lower interest rates can have a lagged effect depending on the state of the economy and the magnitude of the decrease in interest rates. The lag effects on the economy can be as late as 6 to 18 months later, although it is often sooner for the stock market. If indeed policy makers are successful in exerting positive influences on the economy as elections approach, it should be logical to expect less volatility in the stock market. Therefore, risk reduction may also be accomplished if one were invested for only approximately the second half of the U.S. four-year presidential cycle or about 50 percent of the time. The expanding level of liquidity (i.e. money) in the economy, combined with a downward trend in interest rates, are major drivers of stock market performance within the four-year presidential cycle. However, the relationship appears to be a lagging one as discussed earlier.

Policies to stimulate the economy as presidential elections approach strongly contribute to the performance of the four-year cycle. With presidential elections, you need to make sure to have all the components of a diversified portfolio in place, and then stick to a longer-term strategy that’s designed for more than one election cycle. The equity and bond market trends were consistent over time unless there was a dramatic disruption. Keeping an eye on which sectors are most likely to be affected by the presidential election is smart, but there is no need to panic about market volatility during election season.

Adrian Mifsud, Cefa, is an Investment Advisor at Jesmond Mizzi Financial Advisors Limited. This article does not intend to give investment advice and the contents therein should not be construed as such. The Company is licensed to conduct investment services by the MFSA and is a Member of the Malta Stock Exchange and a member of the Atlas Group. The directors or related parties, including the company, and their clients are likely to have an interest in securities mentioned in this article. Investors should remember that past performance is no guide to future performance and that the value of investments may go down as well as up. For further information contact Jesmond Mizzi Financial Advisors Limited of 67, Level 3, South Street, Valletta, on Tel: 2122 4410, or email [email protected]